Everyone knows the major sources of oil and gas that require midstream infrastructure, but what about the sources of investment to build that infrastructure?

In the sector, the answer has been as easy as M-L-P. That structure is responsible for 55.6% of midstream’s market capitalization as of June 29, according to Alerian. The MLP structure also retained its tax advantage over C-corps following the passage of the Tax Cuts and Jobs Act of 2017, albeit a smaller one.

But the industry’s most recent down-cycle unveiled dents in the MLP armor, notably the lack of interest on the part of many institutional investors, that has encouraged the pursuit of other sources of capital.

James Hays

“From our perspective, private equity serves as a more consistent, more available stream of capital than the MLPs in the public markets may serve,” James M. Hays, Houston-based counsel for Simpson Thacher & Bartlett LLP, told Hart Energy. “From our perspective as private equity attorneys, the private equity model affords itself much more customization than publicly traded MLPs do.”

Almost all private equity funds are set up as limited partnerships, a structure that allows contractual customization—for issues such as fee terms, investment discretion and investment guidelines—that is typically unavailable for commoditized products traded in the public market.

“While most people think of private equity in terms of a 10- to 12-year vehicle with perhaps a four- to five-year hold on underlying assets, what you started to see in the infrastructure space is a move toward open-ended funds which might be more focused on yield than absolute return,” David J. Greene, Washington-based partner with Simpson Thacher, told Hart Energy. “These are vehicles that can go on forever and, accordingly, can hold midstream or other infrastructure assets for long term and that can be real desirable both from the asset level and the institutional investor.”

In a report, Greene, Hays and Simpson Thacher partner Michael W. Wolitzer list five private equity structures:

  • Closed-end funds, the most common structure, which utilize a fixed term (eight to 12 years) and investment period (four to six years);
  • Evergreen funds, which feature rolling commitment periods of three to five years and a “series” in which subscriptions are accepted within an initial marketing period and subsequent subscription window;
  • Open-ended funds, a recent trend, follow a modified hedge fund format, include a perpetual term and use a mark-to-market approach—incentive allocation and management fees are based on net asset value and unrealized values;
  • Club funds are commingled fund products, typically comprised of a small number of investors, in which each investor may invest on a deal-by-deal basis; and
  • Separately managed accounts, which are highly customized products involving a single investor, that can develop a structure to meet the needs of sponsors and investors.

Greene and Hays did not dispute the continued viability of MLPs but did note in their report that MLPs don’t keep on hand the cash reserves necessary to pursue large, multiyear development projects and rely on the capital markets to raise new equity or debt. When oil prices collapsed, some were strapped for cash.

As interest rates rise, the midstream sector’s risk-return profile suffers a disadvantage against other investments. The cost of equity for MLPs increases, they wrote, and other sources of capital may be needed to replace that MLP money.

“Private equity has really filled this gap,” said Hays. “It has been a compelling alternative to the MLP market.”

Joseph Markman can be reached at jmarkman@hartenergy.com or @JHMarkman.

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